E. What’s All the Furor Over Executive Compensation? What Academics Say
One explanation for the extreme pay of executives involves social comparisons.
oIn this view, executive salaries bear a consistent relative relationship to
compensation of lower–level employees.
When salaries of lower-level employees rise in response to market forces,
top executive salaries also rise to maintain the same relative relationship.
In general, managers who are in the second level of a company earn about
two-thirds of a CEO’s salary, while the next level down earns slightly
more than half of a CEO’s salary.
Much of the criticism of this theory—and an important source of criticism
about executive compensation in general—is the gradual increase in the
spread between executives’ compensation and the average salaries of the
people they employ.
In 1980, CEOs received about 42 times the average pay of lower-level
workers.
Now top executives are paid more than 300 times the pay of the average
worker.
A second approach to understanding executive compensation focuses less on the
difference in wages between executive and other jobs and more on explaining the
level of executive wages.
oThe premise in this economic approach is that the worth of CEOs, or
their subordinates, should correspond closely to some measure of company
success, such as profitability or sales or firm size.
oThere is empirical support for this explanation.
Numerous studies over the past 30 years have demonstrated that executive
pay bears some relationship to company success.
A recent article analyzing the results from over 100 executive pay studies
found empirical evidence that firm size (sales or number of employees) is
by far the best predictor of CEO compensation.
Size variables are nine times better at explaining executive compensation
than are performance measures.
oSome evidence contradicts this, though.
Research of pay packages at 702 publicly traded U.S. companies
(1995-2004) showed a 1 percent increase in company value led to a 0.43
percent increase in compensation of senior executives. But what was
troubling was the huge variations across the sample. Executive
compensation in some firms was highly related to company value, while at
others there was no relationship whatsoever.
Worse yet, the present value of future compensation (mostly stock options,
which account for about 75 percent of executive pay packages) shows
very little sensitivity to company value.
A variant on this approach argues that environmental performance when
measuring company value should be taken into account. One interesting
study found that environmental performance is an important determinant
of CEO pay in polluting industries.
Two other studies combined both social comparison and economic
explanations to better understand CEO salaries. Both these explanations
turned out to be significant. Size and profitability affected level of
compensation, but so did social comparisons.
In one study, the social comparison was between wages of CEOs and
those of the board of directors. It seems that CEO salaries rose, on
average, 51 percent for every $100,000 more that was earned by directors
on the board.
A third view of CEO salaries, agency theory, incorporates the political
motivations that are an inevitable part of the corporate world.
oSometimes, this argument runs, CEOs make decisions that aren’t in the
economic best interest of the firm and its shareholders.
One variant of this view suggests that the normal behavior of a CEO is
self-protective. CEOs will make decisions to solidify their positions and to
maximize the rewards they personally receive.
oAs evidence of this self-motivated behavior, consider the following
description of how executives ensure themselves high compensation:
If the CEO is truly underpaid: A compensation consultant is hired to
survey actual competitors of the company. The consultant reports to the
board of directors that the CEO is truly underpaid. Salary is increased to a
competitive or higher level.
If the CEO is not underpaid and the company is doing well: Specific
companies are recommended to a consultant as appropriate for surveying.
The companies tend to be selected because they are on the top end in
terms of executive compensation. The consultant reports back to the board
that its CEO appears to be underpaid. Salary is increased.
If the CEO is not underpaid and the company is doing poorly: The CEO
laments with a consultant that wages are so low for top management that
there is a fear that good people will start leaving the company and going to
competitors. The result is that the consultant recommends a wage increase
to avoid future turnover.
oDespite this jaundiced view of the compensation determination process,
agency theory argues that executive compensation should be designed to
ensure that executives have the best interests of stockholders in mind when
they make decisions.
oThe outcome has been to use some form of long-term incentive plan,
most commonly stock options.
oAlthough stock options sound like an effective tool for motivating
executives, there are still many critics.
A number of studies offer contrary evidence that stock options don’t align
CEO interests with those of the firm.
Critics argue, even the method for tying executives to the company is
flawed. One major complaint is that stock options do not have a downside
risk.
If stock prices rise, the options are exercised. If stocks do not improve,
or even decline, the executive suffers no out-of-pocket losses.
Another complaint is that stocks can rise simply because the general
market is rising, not because of some exceptional behavior by the CEO. To
counter this argument about 30 percent of companies force CEOs to meet
some financial performance target before they can exercise their options
Some argue that executive compensation should move more toward
requiring that executives own stock, rather than just have options to buy it.
With the threat of possible financial loss and the hope of possible
substantial gains, motivation may be higher.
Others advocate linking stock options to executive performance.
There is growing recognition that the linkage between performance and
pay is much more complex for executives than was previously thought.
Current work focuses on firm risk, stock ownership versus stock options,
and type of industry as possible additional factors explaining executive
pay
F. Scientists and Engineers in High-Technology Industries
Scientists and engineers are classified as professionals. According to the Fair
Labor Standards Act, this category includes any person who has received special
training of a scientific or intellectual nature and whose job does not entail more
than a 20 percent time allocation for lower-level duties.
To restore the lead in the generation of scientific knowledge, more attention needs
to be paid to knowledge workers who should be paid for their special scientific or
intellectual training. Here, though, lies one of the special compensation problems
that scientists and engineers face.
oFor the first few years after graduation an engineer’s (for example)
knowledge is a valuable resource on projects where new applications of the
latest theories are a primary objective. Gradually, though, this engineer’s
knowledge starts to become obsolete, and team leaders begin to look to newer
graduates for fresh ideas.
oIf the salaries of engineers and scientists are tracked, a close parallel
between pay increases and knowledge obsolescence can be seen (Exhibit
14.7).
oPartly because salary plateaus arise, many scientists and engineers make
career changes such as moving into management or temporarily leaving
business to update their technical knowledge. In recent years some firms have
tried to deal with the plateau effect and also accommodate the different career
motivations of mature scientists and engineers.
oThe answer is something called a dual-career ladder. Exhibit 14.8
shows a typical dual career ladder.
oDual ladders provide two different ways of progressing in an
organization, each reflecting different types of contributions to the
organization’s mission.
The managerial ladder offers a promotion path with increasing
responsibility for management of people.
The professional track rises with increasing technical responsibility.
The idea is that talented technical people shouldn’t feel that they have to
take management jobs in order to advance in their careers, that they can
advance in their careers, that they can advance through the excellence of
their technical work.
A second problem in designing the compensation package of scientists and
engineers centers on the question of equity. The very nature of technical
knowledge and its dissemination requires the relatively close association of these
employees across organizations.
oPerhaps because of this, scientists and engineers tend to compare
themselves for equity purposes with graduates who entered the labor market
when they did.
oPartially because of this and partially because of the volatile nature of
both jobs and salaries in these occupations, organizations rely very heavily on
external market data in pricing scientists’ and engineers’ base pay.
oThe result is the use of something called maturity curves. Maturity
curves reflect the relationship between scientist/engineer compensation and
years of experience in the labor market (Exhibit 14.7).
Scientists and engineers also receive compensation beyond base pay.
oMore than half get a bonus either linked to company profits or personal
performance. The incentives, though, tend to be small, averaging less than five
percent of pay.
oOther incentives link payment of specific cash amounts to completion of
specific projects on or before agreed-upon deadlines.
oPost-hiring bonuses are paid for such achievements as patents,
publications, elections to professional societies, and attainment of professional
licenses.
Organizations have devoted considerable creative energy to development of perks
that satisfy the unique needs of scientists and engineers.
oThese perks include flexible work schedules, large offices, campus-like
environments, and lavish athletic facilities.
oThe strategic importance of this group dictates both mind and body be
kept active.
G. Sales Forces
The sales staff spans the all-important boundary between the organization and
consumer of the organization’s goods and services.
The role of interacting in the field with customers requires individuals with high
initiative who can work under low supervision for extended periods of time.
oThe standard compensation system is not designed for this type of job.
So, there is much more reliance on incentive payments tied to individual
performance.
oThus, even when salespeople are in the field—and relatively
unsupervised—there is always a motivation to perform.
oIf the product is in high demand, and the “sales ability” isn’t a difference
maker, the compensation mix is mostly base salary with a small incentive
component. However, as the sales person’s ability becomes more important,
the size of the incentive component rises significantly.
Designing a Sales Compensation Plan
oSix major factors influence the design of sales compensation packages:
The nature of people who enter the sales profession.
Organizational strategy.
Market maturity.
Competitor practices.
Economic environment.
Product to be sold.
oThe Nature of the People
Popular stereotypes of salespeople characterize them as being heavily
motivated by financial compensation.
One study supports this perception, with salespeople ranking pay
significantly higher than five other forms of reward. In the study, 78
percent of the salespeople ranked money as the number-one motivator,
with recognition and appreciation being ranked as number-two motivator.
Promotional opportunities, sense of accomplishment, personal growth, and
job security were all less highly regarded. These values dictate the primary
focus of compensation should be on direct financial rewards (base pay
plus incentives).
oOrganizational Strategy
A sales compensation plan should link desired behaviors of salespeople to
organizational strategy.
This is particularly true in the Internet age. As more sales dollars are tied
to computer-based transactions, the role of sales personnel will change.
Salespeople must know when to stress customer service and when to stress
volume sales. And when volume sales are the goal, strategic plans signal
which behaviors are important and which products should be pushed
hardest.
Emphasis on customer service to build market share or movement into
geographic areas with low potential may limit sales volume. Ordinarily,
sales representatives under an incentive system will view customer service
as an imposition, taking away from money-making sales opportunities.
Salespeople who are asked to forgo incentive income for low-sales tasks
should be covered under a compensation system with a high base pay and
small incentive component.
Exhibit 14.9 outlines the strategy as a function of type of buyers.
Alternatively, an organization may want to motivate aggressive sales
behavior. A straight commission-based incentive plan will focus sales
efforts in this direction, to the possible exclusion of supportive tasks such
as processing customer returns.
Such incentive plans include both a statement about the size of the
incentive and a discussion of the performance objective necessary to
achieve the incentive. Typical performance measures include:
Overall territory volume
Market share
Number of product placements in retail stores
Number of new accounts
Gross profit
Percentage of list-price attainment (relative to other salespeople in the
organization)
Consistency of sales results
Expense control
Productivity per square foot (especially popular in retail stores)
Bad debt generated by sales
Each measure, of course, corresponds to a different business goal.
A good sales plan also factors in the KISS principle: Keep It Simple
Stupid.
Generally there are two types of compensation plans:
Unit rate plans—differ by the amount they pay for each unit of sales.
Flat commissions have the same rate for each unit sold. Ramped
commissions have one rate up to a target level, and then a higher rate
tied to more difficult “above-target” sales. Declining commissions
offer one rate up to a target level, then lesser rates thereafter.
Add-on plans—tries to get sales staff to focus on specific types of
sales. The sales staff gets an extra incentive for each sale of that line.
Usually this stress on one product is short-lived, and then the focus
turns to yet another sales item.
oMarket Maturity
As the market of a product matures, the sales pattern for that product will
change, and companies need to adapt the compensation for their sales
force accordingly.
A recent study showed that with maturing markets, companies move
toward a more conservative sales pattern, focusing even more on customer
satisfaction and retention. This leads companies to employ more
conservative, rather than aggressive, salespeople, who can comply with
the companies’ customer retention plans.
In maturing markets, companies focus both on performance-based pay tied
to customer satisfaction and on greater base salaries to retain conservative
salespeople.
oCompetitor Practices
In selecting an appropriate pay level, organizations should recognize that
external competitiveness is essential.
This provides the opportunity to chat about relative compensation
packages, an opportunity which salespeople will frequently take.
oEconomic Environment
The economic environment also affects the way a compensation package
is structured.
In good economic climates with roaring sales, companies can afford to
hire mid- and low-level sales personnel to capture the extra sales. In a
recessive environment, however, companies need to react to the
decreasing level of sales by focusing more on the top-level performers and
rewarding those that achieve high levels of sales despite the economic
downturn.
oProduct to Be Sold
The nature of the product or service to be sold may influence the design of
a compensation system.
For a product that, by its very technical nature, is difficult to understand, it
will take time to fully develop an effective sales presentation.
Such products are said to have high barriers to entry, meaning
considerable training is needed to become effective in the field.
Compensation in this situation usually includes a large base-pay
component, thus minimizing the risk a sales representative will face,
and an encouraging entry into the necessary training program.
At the opposite extreme are products with lower barriers to entry, where
the knowledge needed to make an effective sales presentation is relatively
easy to acquire.
These product lines are sold more often using a higher incentive
component, thus paying more for actual sales than for taking the time
to learn the necessary skills.
Products or services that sell themselves, where sales ability isn’t as
crucial, inspire different compensation packages than do opportunities
where the salesperson is more prominent.
Base compensation tends to be more important with easily sold
products.
Incentives become more important when willingness to work hard may
make the difference between success and failure.
Figuring out what the sales target should be is a major challenge. Too easy
a target and the sales staff receive undeserved compensation.
An impossible target, in contrast, can be demotivating.
The second biggest challenge is making the forecast of expected sales as
accurate as possible.
The linkage between these two issues is clear. Bad forecasts lead to
inaccurate goals.
Most jobs do not fit the ideal specifications for either of the two extremes
represented by straight salary or straight commission plans. A combination
plan is intended to capture the best of both these plans.
A guaranteed straight salary can be linked to performance of non-sales
functions while a commission for sales volume yields the incentive to sell.
A plan combining these two features signals the intent the organization
to ensure that both types of activities occur in the organization.
H. Contingent Workers
A contingent worker is defined as anyone hired:
oThrough a temporary-help agency
oOn an on-call basis
oAs an independent contractor
Workers in the first two categories typically earn less than workers in traditional
arrangements; those in the latter category earn more.
oFor example, working through a temporary-help agency usually means
low pay in administrative or day labor positions. In contrast, the wages for an
independent contractor might be higher than those for a more permanently
employed counterpart.
Because the employment status of contingent workers is temporary and employee
benefits are less or nonexistent, wages at times tend to compensate by being
somewhat higher.
Employers must be sure to follow the rules about when workers are independent
contractor/ consultants and when they are common law employees.
Why the move to contingent workers? One answer may signal a permanent
change in the way business is done.
oAs the U.S. comes out of the “Great Recession” companies are not
hiring at the level we would expect. Rather, they are taking on temporary
workers as a way to insulate themselves in a volatile economy.
oTemp workers afford a level of flexibility that allows expansion and
contraction of the workforce in response to market changes.
A major compensation challenge for contingent workers is identifying ways to
deal with equity problems. Contingent workers may work alongside permanent
workers yet often receive lower wages and benefits for the same work.
Employers deal with this potential inequity on two fronts, one traditional and one
that challenges the very way people think about employment and careers.
oOne company response is to view contingent workers as a pool of
candidates for more permanent hiring status. High performers may be moved
off contingent status and afforded more employment stability.
oA second way to look at contingent workers is to champion the idea of
boundary-less careers. At least for high-skilled contingent workers, it is
increasingly popular to view careers as a series of opportunities to acquire
valuable increments in knowledge and skills.
In this framework, contingent status isn’t a penalty or cause of
dissatisfaction. Rather, employees who accept the idea of boundary-less
careers may view contingent status as part of a fast-track developmental
sequence.
Lower wages are offset by opportunities for rapid development of skills—
opportunities that might not be so readily available in more traditional
employment arrangements.